“We Have Met the Enemy… And He is Us” is the very fitting title of a recent report on the state of the VC market with a focus on the GP-LP relationship. This thoughtful and thankfully analytical report highlights a series of lessons from 20-years of venture investing by the Kauffman Foundation.
Its received lots of coverage in the media (here, here) and blogosphere, including an excellent pair of posts from my partner Fred Destin (here, here), and should be required reading for those interested in the venture ecosystem.
It’s fair to say, though, that many of the themes highlighted by the report are not “new” news, but they’ve put quality analytics behind a number of these points. Insiders have long known about most of these issues, and I’ve discussed many here in this blog. Some reflections on a few key points:
- The “venture capital math problem” places real constraints on the returns achievable by large funds. The simple math, and the unimpressive data for >$500M funds, have been covered elsewhere (here, here). More funds in the $250M range have delivered handsome returns than any other size. It’s particularly relevant in biotech where Facebook-sized exits aren’t even a remote possibility, as I covered in a recent post looking at the assumptions required to deliver “venture-like” 3x gross returns. At Atlas, we’re true believers in the “small is beautiful” mantra: our most recent fund is ~$280M and anticipate similar sizes going forward. We know the consequences of big funds because we’ve made those mistakes at Atlas. In the bubble, Atlas raised far too much, far too fast, and invested like drunken sailors (much like everyone else). For the past decade, we’ve been working hard to get LPs their capital and then some. As most in the industry know, the bubble vintage funds of 1999-2001 will probably go down as the worst years in the history of venture capital. Lots of lessons learned, but its clear to us that in the long run smaller funds are better for LPs, GPs, and entrepreneurs.
- Partnerships are complex and often blackbox, and understanding what being a “partner” really means should be important to LPs. Partner titles can mean lots of things: GPs, key men, junior partners, managing directors, operating partners, venture partners – the industry uses a bunch of terms for different roles and there is no consistent definition. And the economic fund flows within partnerships often require armies of accountants. These oddities certainly create confusion. I can’t speak for other partnerships, but I think we’ve got this right (finally): Atlas has undergone an evolution since I joined in 2005, and is a much healthy, leaner partnership today. We’re now a flat, equal partnership with six GPs and are exclusively focused on early stage innovation in life sciences and technology. The cohesion of the team and clarity of the strategy is part of why I love coming to work in the morning.
- The median venture fund underperformed the public markets in the Kauffman portfolio. This is certainly true, and affirms what insiders have long known about returns. And no LP invests in venture hoping for a median performer. What’s also true is that the median managed mutual funds underperform the passive equity markets (e.g., according to Vanguard, 84% of actively-managed U.S. large blend funds underperformed their index for the decade prior to 2007). Actively managed asset classes aren’t about the median performer: they appeal because top quartile performers can vastly outperform.
So in general, I’m in complete agreement with the big themes in the report.
That said, there are a few nuances worth mentioning:
- The “vaunted J-curve” was challenged as a myth in venture. The J-curve has been described elsewhere, but in summary its that value of a VC fund may post negative IRRs in the early years as money is spent on deals and expenses, but no exits or upticks in value have been achieved. The Kauffman report does a good job of showing that many VC funds (Tech-biased) didn’t actually have a J-curve: that is, they achieved rapid paper write-ups in the value of their portfolio (and then use those write-ups to raise their next fund). But I don’t think it’s a myth in early stage life sciences: biotech deals don’t typically achieve big write-ups early in their lives. Bijan Salehizadeh has written on the “unrealized” problem in biotech, which is the product of the lack of these write-ups. Many remain flat for 4-5 years and then, if successful, hockey stick upward with a favorable M&A exit, like Avila Therapeutics prior to its deal with Celgene, for instance. The reason VCs like Atlas like to get into startups early that are likely to be held at flat valuations for years is to shape the DNA and direction of a company while securing out-sized ownership stakes. Many great deals, like Plexxikon, didn’t raise money for the 8 years prior to their exit – so getting in early was the only way to get into those deals. So, at least from my limited experience, early stage biotech venture portfolios more often than not exhibit a J-curve early in the life of fund. But its fair to say that “the plural of anecdotes is not data” and I’d love to see an aggregate dataset on this.
- There’s a reference to liquidation preferences and how VCs apply them to their portfolio but not themselves. Before the bubble of 2000-2001, it was more common to pay carried interest on a deal-by-deal basis (which led to the clawback problems when the funds were underwater), but these terms are less common today. Our LPA, like many others, effectively has a liquidation preference in place: VCs are only paid a share of the profits when all the committed capital and fees have been paid back. This is the equivalent of a 1x liquidation preference feature in a typical startup, except that its over the entire fund.
- Kauffman recommends that LPs invest directly into a portfolio of startups. I’m generally supportive of LPs investing directly, but making sure it’s alongside “trusted” investors is key. I’m a firm believer that startups benefit a great deal from having value-add, high quality venture capitalists involved on their boards. Good VCs also bring the best of their entire firm to bear on a portfolio company’s issues across a spectrum of company-building activities: corporate strategy, business development, resource allocation, etc… So if LPs are going to “go direct” to avoid the fees and profit-sharing of a VC investment, its definitely worth teaming up with some trusted co-investors.
As I’ve said before, the venture model is clearly in flux – hopefully better returns from some of the experiments we’ve been doing in biotech venture capital will bring back some of the enthusiasm for the asset class.
Post was updated after a good discussion with Diane Mulcahy of the Kauffman Foundation, who among other good comments had correctly pointed out that a number of funds are paid carried interest once invested capital has been returned, rather than total committed capital.
